Two firms, U and L, are identical except for their capital structure. Both own a

Question

Two firms, U and L, are identical except for their capital structure. Both own a single perpetual asset that will have annual after tax-free cash flows of $25million in a boom and $5million in a slump. There is a 50% chance of each event. U is entirely equity financed, and therefore equity shareholders receive the entire free cash flow. For U, the equity beta is 1.6. Firm L has issued debt at the risk free rate, has a debt-to-equity ratio of 1/3, and its equity beta is 1.95. Assume that the risk-free rate is 4%, the market risk premium is 5% and the tax rate is 35%. Report your answers to the nearest $million.

What is the value of firm U in $millions?

What is the value of firm L in $millions?

Explanation / Answer

Two firms, U and L, are identical except for their capital structure. Both own a

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